Schumpeter, Joseph (1883-1950)

A giant among 20th-​century economists, Joseph Schumpeter is best known for his path-​breaking work on capitalism, innovation, entrepreneurship, and growth. He coined the phrase creative destruction to describe capitalistic growth as the ceaseless killing off of old ways of doing business by the new. He is not often thought of as a libertarian. Nevertheless, with his love of free markets; his stress on human freedom, initiative, and drive to succeed as the mainspring of growth; his belief in capitalism as the best, arguably the only, system capable of continuously raising the living standards of all (especially the poor); his focus on the lone-​wolf entrepreneur who against all odds creates the new products, markets, technologies, and organizations that propel the economy forward; his opposition to government regulation of economic and business activity; his public choice views of democracy; and his hatred of war, Schumpeter has much in common with libertarians.

Born in Triesch, Moravia, Schumpeter was a high achiever. By the time he was 31 years old, he had earned a PhD from the University of Vienna, had been appointed professor at the Universities of Czernowitz and Graz, amassed a substantial fortune as a lawyer and financial advisor to an Egyptian princess in Cairo, published three books and numerous papers, and received an honorary doctorate from Columbia University. After stints as Minister of Finance for a post–World War I Austrian socialist government and president of a Viennese private bank that collapsed in 1924, leaving Schumpeter bankrupt, he returned to academia, holding a chair at the University of Bonn (1925–1932) and then moving to Harvard in 1932, where he taught for the rest of his life.

Schumpeter pushed one big idea all his life: that capitalism means growth and growth requires innovation. His most original book, The Theory of Economic Development (1912), states for the first time his view that capitalism is the system that delivers faster growth and higher living standards than any other system, albeit in a disruptive, jerky, anxiety-​producing fashion. Like a perpetual motion machine, capitalism generates its own momentum internally without the need of outside force. Even technological change, seen by some as an exogenous propellant, is treated by Schumpeter as a purely endogenous matter, the product of economically motivated human ingenuity.

Upon the static, steady-​state equilibrium, circular-​flow model of the neoclassical marginal utility/​marginal productivity school, Schumpeter erects a dynamic disequilibrium theory of cyclical growth. His key building blocks are profits, entrepreneurs, bank credit creation, and innovation. Profits (supplemented perhaps with a desire to create a business dynasty) motivate entrepreneurs, who, financed by bank credit, innovate new goods, new technologies, and new methods of management and organization. These innovations fuel growth and generate cycles.

Why cycles? Schumpeter maintained that they start with a mass of potential innovations seeking to override the forces of habit, custom, and tradition blocking their realization. When the first successful entrepreneur overcomes the stubborn resistance of incumbent interests and eases the path for other entrepreneurs, the ensuing wave of innovation boosts aggregate investment spending. The extra spending bids prices above costs and raises profit margins, thereby triggering the upswing or prosperity phase of the cycle. The high profit margins then attract swarms of imitators and would-​be competitors into the innovating sectors. Output overexpands relative to the demand for it, prices fall to or below costs, thus eliminating profit margins, and a downswing or recession phase begins. The recession continues, weeding out inefficient firms (including traditional ones whose customers desert them for their innovating rivals) as it goes, until the economy absorbs the innovations and consolidates the attendant gains, thus clearing the ground for a fresh burst of innovation. If the upswing has been accompanied by speculative excesses nonessential to innovation, the downswing may overshoot the new postinnovation equilibrium. Then the cycle enters its depression phase, where the excesses are expunged and the economy returns via a recovery phase to equilibrium. Schumpeter stressed that the latter two phases and the phenomena that generate them are unnecessary for growth and could be prevented by properly designed policy. It is not speculative bubbles, Schumpeter argued, but rather the discontinuous clustering of innovations in time plus their slow diffusion across and assimilation into the economy that produces real cycles of prosperity and recession.

Profits, entrepreneurs, bank credit, and innovation are all essential to the growth of per capita real income in Schumpeter’s model. Remove any one and the growth process stops. Innovation, for instance, is abortive in the absence of bank credit creation necessary to effectuate it. Cash-​strapped entrepreneurs cannot create new products and technologies from thin air. They require real resource inputs and loans with which to hire those resources away from outmoded firms and uses. Schumpeter noted that resource transfer is facilitated by price inflation generated by newly created money. Inflation cuts into the real purchasing power of consumers and noninnovating firms, thus reducing their command over productive resources that are freed for employment by the innovating sector. In highlighting these points, Schumpeter effectively abandoned the so-​called classical dichotomy according to which loan-​created money is a mere sideshow, a neutral veil that, together with metallic money, determines the nominal or absolute price level while leaving real economic variables unaffected. Not so, said Schumpeter. For him, money and credit are integral to the process of real economic growth and so have real effects.

As the leading defender and apostle of capitalism, Schumpeter was a severe critic of the dominant Keynesian thinking of the 1930s, 1940s, and 1950s, thinking preoccupied with stagnation rather than with growth. He accused Keynes of assessing capitalism on the basis of a short-​run, depression-​oriented model when only a long-​run growth-​oriented one would do. He noted Keynes’s neglect of innovation, the mainspring of capitalistic growth. He scorned Keynes’s claim that mature capitalistic economies tend to be perpetually underemployed and in need of massive government deficit spending to shore them up. He attacked the “secular stagnation” notion that capitalists face vanishing investment opportunities and slowing rates of technological progress when the opposite is true. He rejected the contention that income must be redistributed from the rich (who save too much) to the poor (who cannot afford to save) in order to boost consumption spending and aggregate demand. Nonsense, said Schumpeter. The insatiability of human wants ensures that income, regardless of who receives it, will be spent in one way or another. Schumpeter’s criticisms, although valid, penetrating, and correct, had little impact on a profession sold on Keynesian stabilization policies.

Even so, Schumpeter evidently erred when he opined that the Keynesian-​style permanently mixed economy or public sector–private sector partnership was unsustainable and could not last. The private sector, Schumpeter reasoned, would become addicted to government expenditure stimulus and demand it in ever-​increasing amounts. Furthermore, labor unions would demand increasingly frequent and aggressive intervention to equalize incomes. In these ways, the public sector would expand relative to the private one, and the economy would gravitate to socialism. Time has proved Schumpeter wrong. Private and public sectors have coexisted in a fairly stable ratio in most developed countries for the past 60 years.

Schumpeter voiced politically controversial opinions in the 1930s when New Deal activism and populist antibusiness sentiments were on the rise. He opposed President Roosevelt’s New Deal reforms on the ground that they hampered entrepreneurship and growth. Similarly, he opposed Keynesian macro demand-​management policies designed to tame the trade cycle. In his view, because growth is inherently cyclical, flattening the cycle comes at the cost of eliminating growth. Other controversial opinions, all corollaries of his work on innovation and creative destruction, flowed from his pen.

On income inequality, he wrote that the gap between rich and poor is a prerequisite to and a relatively harmless byproduct of growth in a capitalistic economy. The rich are necessary because it is they and not the poor who save and invest in the innovation-​embodied capital formation that lifts the living standards of all. Besides, high incomes provide both incentive and reward for the entrepreneurs who propel growth. No one needs fear that an unequal distribution will condemn them to poverty. The notion of the “circulation of the elites” ensures that. The ceaseless rise and fall of entrepreneurs into and out of the top income bracket means that it will be occupied over time by different groups of people, many of them drawn from the ranks of the poor. The poor replace the rich, and the rich the poor in never-​ending sequence.

In assuming a high degree of mobility across income groups, Schumpeter may have overlooked an education barrier. He failed to acknowledge that a superior education, increasingly a prerequisite to entrepreneurship and wealth in today’s high-​tech world, is more affordable by the rich, extending to the offspring of the rich somewhat of an advantage.

As for monopolistic firms and monopoly profits, they bothered Schumpeter not at all. He thought that monopolies, unless protected by government, are short-​lived, inherently self-​destroying, and require no antitrust legislation. Their high profits attract the very rivals and producers of substitute products that undercut them. For the same reason, he regarded antitrust laws aimed at breaking up large, nonmonopolistic firms as ill-​advised. Not only are big firms often more efficient than small ones, but their research and development (R&D) departments house teams of specialists functioning collectively—and routinely—as innovating entrepreneurs. Indeed, the very existence of R&D departments indicates that big firms realize they must continually innovate to stay alive.

Schumpeter’s politically contentious opinions continued into the wartime years of the 1940s. He distrusted Roosevelt, suspecting him of trying to establish a dictatorship. He had mixed emotions about the Axis nations, Germany and Japan. He despised their military establishments, leaders, advisors, and social policies, but he admired the people and cultures of the two countries and feared that the United States would impose punitive reprisals at war’s end. Most of all, he saw the United States’ wartime ally, the Soviet Union, as its chief long-​term foe, and thought that America would need Germany and Japan to serve as buffers against the communist nation. These views found little sympathy among Schumpeter’s friends and associates in the ultrapatriotic environment of the early 1940s, a circumstance that caused him much unhappiness.

Some have seen similarities between Schumpeter and Karl Marx (an economist much admired by Schumpeter). Both sung hymns of praise to capitalism’s prodigious accomplishments, and both predicted the system’s death. Whereas Marx prophesized that capitalism’s failures and internal contradictions would be the cause of capitalism’s destruction, Schumpeter, in his Capitalism, Socialism and Democracy (1942), predicted that the system’s successes would mark its end. These successes will produce social forces—the routinization and depersonalization of innovation, the puncturing of the image of the entrepreneur as romantic hero, and the creation of a class of intellectuals hostile to capitalism—that undermine the system and lead to its demise. Capitalism will give way to socialism, which will take the form of a democratic welfare state that seeks not growth, but distributional equality. The transition to socialism will be easier, Schumpeter noted, if capitalism has created wealth in such abundance that further growth, rendered impossible by socialism’s hobbling of entrepreneurs, is unnecessary.

Schumpeter viewed democracy as a political market in which politicians compete for the votes of the electorate just as producers compete for consumers’ dollars in markets for goods and services. But Schumpeter, always skeptical of consumer rationality, believed that market power resides more with vote seekers than with the electorate, whose apathy, ignorance, and lack of foresight enable politicians to set the policy agenda and to manipulate voter preferences. Even so, he felt that capitalism, provided it operated within a proper legal framework, is largely self-​regulating. Thus, it constrains politicians’ market power more than does socialism where such constraint is absent. These ideas mark Schumpeter as a forerunner of the modern public choice school.

The triumph of global capitalism disproves or at least renders premature Schumpeter’s predictions of capitalism’s death and the inevitable march into socialism. Schumpeter’s work is valuable today not for its predictions, but for its seminal and lasting insights into the nature of capitalism, innovation, entrepreneurship, and creative destruction.

Further Readings

Harris, S. E., ed. Schumpeter: Social Scientist. Cambridge, MA: Harvard University Press, 1951.

McCraw, Thomas K. Prophet of Innovation: Joseph Schumpeter and Creative Destruction. Cambridge, MA: Harvard University Press, 2007.

Schumpeter, Joseph A. Capitalism, Socialism and Democracy. New York: Harper, 1942.

———. The Theory of Economic Development. Cambridge, MA: Harvard University Press, 1934.

Stolper, W. F. Joseph A. Schumpeter, 1883–1950: The Public Life of a Private Man. Princeton, NJ: Princeton University Press, 1994.